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Aggregate Approach to Partnership Causes S Corporation Taxation

One of the more confusing questions
partnerships face is when to use the so-called aggregate or
entity approaches. Most partnerships apply the entity
approach in determining partnership income; they use the
aggregate approach for other decisions. The Tax Court
recently considered which approach entities outside the
partnership arena—where there is even less guidance—should
use.

Coggin Automotive Corp. was a C corporation
that owned six C corporations. Each operated a car
dealership using the LIFO inventory method. The group filed
a consolidated tax return. Luther Coggin decided to
restructure the subsidiary corporations to permit the
general manager of each dealership to acquire an ownership
interest and to provide a means for these managers to buy
him or his estate out when he retired or died. To do this
Coggin completed a number of transactions, including these:

Each of the six subsidiaries transferred its
assets (the dealership) to a newly formed limited
partnership in exchange for a 99% limited partnership
interest.

The subsidiaries were liquidated, transferring
the limited partnership interests to Coggin Automotive,
which then made an S corporation election.

The IRS
determined that Coggin Automotive was required to report the
LIFO reserves in the partnerships as income on its final
return, as required under IRC section 1363. Coggin appealed.

Result. For the IRS. The government
presented two arguments for its proposed tax treatment.

Argument 1. The IRS said the restructuring was a
sham and should be ignored. It also argued that Coggin
Automotive should be treated as owning the LIFO inventory
before and after the S election, which would result in
income recognition under section 1363. In responding to this
argument, the Tax Court acknowledged that, while tax savings
may have been a consideration, the restructuring involved
unrelated third partners and Coggin Automotive was motivated
by significant nontax considerations. As a result the court
concluded the transaction was not a sham and could not be
ignored.

Argument 2. The IRS argued that the aggregate
approach to taxation should be applied to the partnership,
which meant treating Coggin Automotive as owning 99% of the
LIFO inventory subject to section 1363. The company argued
in favor of the entity approach, viewing the issue as one of
income determination where, under partnership taxation
(subchapter K), this approach usually applied. In response,
the Tax Court decision cited cases that applied both the
entity and aggregate approaches to determining tax outside
the partnership itself. The one thing all these cases had in
common was that the decisions were based on which approach
more closely fulfilled congressional intent.

Examining the intention behind section 1363 revealed that
Congress was concerned taxpayers might find a way around the
built-in gains tax imposed on S corporations that were
previously C corporations. According to the Tax Court, the
aggregate approach was more likely to produce the results
Congress intended. Therefore, applying this approach, it
treated the new S corporation as owning 99% of the LIFO
inventory, thereby subjecting the old C corporation to tax
under section 1363. If courts uphold the Tax Court’s
reasoning in future cases, taxpayers will have a rule for
determining the proper approach to partnership taxation
outside the partnership itself. At the same time, this
leaves the congressional intent still open to debate.